Still consolidating

Precious metals are still in a consolidation and the outlook does not point to a short-term breakout to the upside. The past week was mixed for precious metals, after moving higher at the start of the week, prices came down again. Gold and palladium manage to end higher than the week before, while silver and platinum closed lower than the preceding Friday.

The positive start into the trading week was caused by the US labor market report released the Friday before. Some buyers of precious metals speculated that the lower than expected number of new jobs would induce the Fed to embark on the third round of quantitative easing. A look at the yield on 10yr US Treasury notes indicates also that bond investors are still convinced that the Fed would implement QE3 as yields declined further this week. However, those buyers overlook an important fact. The unemployment rate has declined further to 8.2%. And comments of some FOMC members indicate that the Fed is currently not considering any additional monetary stimulus. The indication to be ready to act when needed should not be misunderstood as this would be currently the case. Thus, the FOMC is likely to disappoint the expectations of Wall Street at the next FOMC meeting on April 24/25.

In the case that the FOMC does not indicate to prolong “operation twist” beyond the scheduled expiration by the end of June or to take any other measures of QE3 – as we expect - then the markets are likely to react as they did in March. The US dollar might strengthen against the major currencies and stock market indices and bond prices are likely to come down. This would also have a negative impact on the prices of precious metals.

We pointed out several times that it is a typical behavior of economists to become too optimistic after they have underestimated economic data for some month. This is currently the case. US economic data is coming in mixed. The PMI surveys for the manufacturing and service sector point to still robust growth. However, after some data came in lower than expected, the financial markets already fear a significant slow-down of US GDP growth. The risk-aversion of investors has risen and falling stock markets have also a negative impact on precious metals.

The eurozone debt crisis is back in the focus after last week as Spain sold new paper at the lower end of the target range only. Italy could sell sufficient amounts at auctions this week. However, as yields have risen since the preceding auction in March, some fixed income strategists and traders were concerned about the higher yields Italy had to accept according to market comments. Yields and CDS rates on Spanish and Italian debt rose. The situation calmed down after the member of the ECB directorate responsible for the bond purchase program, Mr. Benoit Coeure, indicated that the ECB could buy bonds of the two countries in the secondary market again. However, on Friday, the president of Netherland’s central bank, Mr. Klaas Knot, send jitters again among market participants by stating that renewed bond buying would be a far way off.

Mr. Knot’s comment was rather stupid for several reasons. First, it is the ECB directorate to decide about the timing of any bond buying in the secondary market. ECB president Draghi just recently confirmed that the security market program is not terminated. Second, After Mr, Coeure calmed down the fears in the bond market somewhat without any bond purchase this week, Mr. Knot has done the speculators attacking Spain and Italy a big favor. While he and the German Bundesbank president Weidmann oppose the bond buying program, the comment of Mr. Knot is counterproductive. Further pressure on Spain and Italy could induce the majority of the ECB council to vote for renewed bond purchases. Keeping his mouth shut would have avoided this.

The comments from the head of the Dutch central bank had not only negative consequences on the government bond prices of Spain and Italy. Stock markets turned negative and plunged after his comments. The euro weakened against the US dollar. In this environment, the safe haven had been the German Bunds and the US Treasury notes and bonds, but not the precious metals. Being regarded currently as risky assets, precious metals turned also lower after the comments from Mr. Knot.

As the eurozone debt crisis is back at centre stage and investors fear a slow-down of global growth, especially after China’s GDP growth came in lower than expected, the markets for precious metals are likely to remain in a sideways trading range. Currently, we see the risk more biased towards the downside. However, should the ECB surprise the markets by buying Spanish and Italian bonds again, also precious metals might move higher again.

Gold at risk of falling below 1600$/oz

Falling stock markets and a stronger US dollar might lead to further losses in precious metal markets. Gold bounced back at the upper end of a support zone last week. However, a renewed attack at the support zone and a fall below 1600$/oz can not be ruled out. In this case, gold would be at risk to visit the low from December last year again.

Two factors were responsible that weak stock markets and an appreciation of the US dollar pulled precious metal prices down last week. First, the FOMC minutes did not contain any hint that the Fed would embark soon on implementing another round of quantitative easing, called QE3. This should not come as a surprise. Even as the CPI is not the favorite inflation gauge of the Fed, but with core CPI inflation at 2.3% and headline inflation at 2.9% in February, some FOMC members are reluctant to increase the balance sheet of the Fed further. In addition, the recent GDP growth of 3.0% in the final quarter of 2011 does not indicate that another stimulus would be needed currently. However, the reaction in the stock and the foreign exchange markets was not rational at all. The Fed policy is expansionary as interest rates will be kept at extremely low levels into late 2014. The strong growth of the US economy should be positive for the stock market. Thus, there is no reason to liquidate stock positions because the Fed is currently not willing to get even more expansionary. However, there is also no reason to buy now US dollars because the Fed Funds rate is extremely low. There is still an incentive to borrow funds in US dollars and to invest abroad or in precious metals given the development of the US CPI inflation and the low opportunity costs for holding gold.

After the release of the US labor market report on Good Friday, the S&P 500 futures plunged further and the 10yr US T-Note future jumped by more than 1.25 percentage points. Instead of 202 thousand, as the consensus of Wall Street economists expected, only 120 thousand new jobs were created in March. However, the unemployment rate declined to 8.2% while the consensus was looking for an unchanged reading of 8.3%. Also the number of jobs created in the previous month had been revised up. The ADP estimate of private sector employment released only a few days earlier pointed to a robust new job creation around 200 thousand. True, the ADP report has not a good track record. Nevertheless, we are also skeptical that the labor market report for March paints the real picture. The numbers of new jobs created are revised up even two months after the first release. Furthermore, seasonal adjustment procedures could lead to distortions as the impact of the weather can not be eliminated completely. Normally, some confirmation for a worsening of the labor market situation would be needed. However, the labor market report could weigh further on the stock market as investors might fear a slow-down of the US economy. Also some hope for QE3 at the next FOMC meeting might revive. Thus, the risk appetite of investors could decline further, which would also be negative for the precious metals.

The second factor is the debt crisis in the eurozone, where the focus has now shifted to Spain. Initially, Spain planed to reduce the budget deficit, which ballooned after the financial crisis of 2007/08, to 4.4% of GDP in this year. However, this intention was based on higher GDP growth forecasts. But due to the Franco-German mismanagement of the debt crisis by Merkel and Sarkozy, GDP growth is not only lower, but Southern European economies face the risk of a recession. The new elected government of Mr, Rajoy took the right measures to reduce the budget deficit, but to the extent necessary to reach the original target for the deficit/GDP ratio. He was warned by the vicious circle of budget cuts and GDP slump in Greece. But bond vigilantes and traders at major investment banks were too dumb to understand this. If a recession is looming, sound macroeconomic policy would not increase the recession risk by implementing more austerity measures. The bond market had doubt that Spain would reduce the deficit/GDP ratio. As Spain sold notes only at the lower end of the target range last week, the bond market panicked and a new flight into safe haven Bunds set in. The case of Spain illustrates perfectly, that what might be sound microeconomic behavior could have devastating impacts on the macroeconomic level. However, also the euro got under pressure against the US dollar and stock markets plunged, which were additional negative factors for precious metals.

Fears of a slow-down of global economic growth and Spain getting into the centre of the debt crisis in the eurozone could be the main factors also for the new trading week. Thus, it could not be ruled out that precious metals remain under some pressure.   

Up and down on Ben

Precious metals remain in a consolidation. Most precious metals managed to end the week slightly higher compared with the preceding weekly close, only palladium ended lower. But they could not defend the gains made at the beginning of the week and pared most of the earlier advance.

The major event for the precious metal markets had been a speech given by Fed chairman Bernanke at the National Association of Business Economists on “Recent Developments in the Labor Markets”. The main message of this speech is that the Fed chairman is not sure whether the improvement of economic growth is already self-sustainable. Therefore, he favors that the Fed will maintain its current course of expansionary monetary policy.

The initial reaction at the stock markets was positive as hopes for QE3 were revived. However, over the course of the week, the doubts of Bernanke turned into a burden for stock markets. We pointed out here that if economists are too pessimistic and economic data comes in better than expected for some time, then economists get more bullish and overestimate the economic figures. The data for the US economy released last week was mixed. However, after the Bernanke speech, the market focused only on the negative surprises. The best example is the durable goods orders data. While the new orders for core capital goods came in better than the consensus of Wall Street economists predicted, the overall new order figure was below consensus. The new orders for core capital goods provides a better picture of the underlying trend as it is not distorted by large ticket orders. Nevertheless, the financial markets focused on the overall figure and got concerned again about global growth.

Bernanke’s speech also gave the euro a lift against the US dollar, which rose again above 1.335. The US dollar index declined again towards 90.0. However unlike the stock markets, the euro and other major currencies defended the gains versus the US dollar and traded sideways. This gave the precious metals some support, but it was not sufficient to compensate the negative impact of stock markets paring gains.

The crucial question remains, what does the Bernanke speech imply for monetary policy? Expecting that the Fed would embark on implementing QE3 would be far too optimistic. As we already pointed out some weeks ago, the best one might expect is that the FOMC will extend “Operation Twist” beyond the scheduled deadline at the end of June. However, operation twist is not quantitative easing in the usual sense of extending the balance sheet of the Fed. With operation twist, the balance sheet of the Fed remains unchanged as short-term Treasuries are sold and longer-term Treasury notes and bonds are bought. Operation twist aims at flattening the yield curve and reducing the level of yields at the medium- to long-term part of the yield curve. After terminating operation twist, the risk is that yields on longer dated US Treasury notes and bonds increase again. Thus, the Fed might decide to extend operation twist with the intention to keep yields on Treasuries fairly stable and thus, that also yields on corporate and mortgage bonds remain stable.

Therefore, from our point of view, financial markets got too excited about US monetary policy getting more expansionary. A significant extension of the Fed balance sheet would require a slow-down of US GDP growth and slower creation of new jobs. However, in this case, also stock markets would head lower. But this scenario would also be negative for the precious metals.  

Metals on the decline, but for how long

Base metals and precious metals posted losses this week with the exception of gold, which managed to end the week marginally higher due to a rebound on Friday. While the US dollar on balance was a supportive factor for metals, the two other major drivers were not. After investors preferred risky assets in the week before, safe haven government bonds were in demand again since the middle of the week. The reason for the increased risk aversion is a renewed fear about global growth.

A well received auction of 2yr German government notes (Schatz) was the trigger for a rebound of safe haven buying. This move accelerated with the presentation of the UK budget. Furthermore, fears about Spanish public finances flared up again, which drove yields on Spanish government bonds up and the prices of safe haven German Bunds rallied. This recovery of bond markets had already a negative impact on stock markets and also on metal markets. This reaction in bond markets demonstrates again that financial markets are not always rational as academic theory postulates. The new Spanish government has made a wise decision. The austerity measures already implemented and the eurozone debt crisis cause a slower nominal GDP growth than previously expected. This has of cause an impact on the budget deficit, which would not decrease in per cent of the GDP as much as intended. Instead of imposing further austerity measures, the new government of PM Rajoy decided to accept a lower decline of the deficit/GDP ratio. Another round of spending cuts or tax hikes would have a much more severe impact on GDP growth and could be even counter-productive as the case of Greece shows. The bond vigilantes also overlook that Spain has already included rules of balancing the budget in the constitution. Spain also pledged to reduce the budget deficit further, but will not take measures, which could deepen the recessionary developments.

Metals markets came under stronger selling pressure on Thursday after the release of flash PMI surveys. In China, the HSBC manufacturing PMI dropped from 49.6 to 48.1. The official Chinese PMI is currently above the 50 mark. Furthermore, it is not always moving in the same direction as the HSBC PMI. However, also in the eurozone, the manufacturing and the service sector PMIs surprisingly declined and even Germany was not immune against a weaker economic outlook in other eurozone countries.

There is a widespread believe that a reading of the PMI below 50 would imply that economic activity is contracting and that a reading over 50 would imply expanding activity. This also explains that journalists at a business TV station stated that China would be in a contraction for the fifth months in a row. However, this 50 mark is not a sharp threshold. Quantitative analysis shows that even with a PMI at 48 the industrial production might increase compared to the same month of the preceding year.

A further point to keep in mind, when interfering from the PMI level to economic activity, is the construction of this index. The PMI is a diffusion index. A sample of purchasing managers is surveyed and the percentage of negative replies is subtracted from the percentage of positive responses. This balance fluctuates around zero. In order to keep the values of the PMI positive, 50 is added to the balance of positive vs. negative replies. However, not all companies included in the sample have the same size and the same contribution to industrial activity. Larger sized companies usually contribute more to industrial production than smaller ones. Thus, the distribution of responses over various classes of company sizes also plays a crucial role. Consider the following scenario where there might be more negative replies from small companies than from large companies. This would be negative for the PMI and could lead to a reading below 50. However, the production increase at large companies could over-compensate the shortfall at smaller companies and thus, overall industrial production could increase.

Chinese recent economic data is sending some conflicting signals. According to the latest figures from the customs office, Chinese copper imports reached the third highest level last month. Rising copper imports don’t argue for a massive slow-down or even contraction of economic activity in China. Some analysts argued that copper was only imported to serve as collateral for short-term funding. This argument is rubbish because it does not make any economic sense to buy copper solely for the purpose of using it as collateral. Of course, companies use copper inventories as collateral for short-term funding. However, importing copper serves the primary purpose of maintaining a certain level of inventories. If companies import more copper then they expect a pick-up of future domestic copper consumption. Furthermore, copper inventories at LME warehouses are declining.

All in all, we expect that metal markets are likely to remain in a consolidation and trading range market for the time being. Growth concerns bias the risk to the downside. However, monetary policy is expansionary in the US and Europe. Also the Chinese central bank started to loosen monetary policy. This should prevent a hard landing. We expect therefore that metal prices would be higher, in particular in the second half of this year.    

Precious metals and the Fed

The major driving factor for precious metals, which all ended the week lower with gold and silver suffering most, was the FOMC meeting. Thus, we look closer at the impact of the Fed policy on precious metals. We conclude that the risk is more biased to the downside.

The flight into safe haven assets was not only driven by the development in Greece, but also by the monetary policy of the Federal Reserve System in the US. On the one hand, the current “Operation Twist” has pushed yields on longer dated US Treasuries lower as private investors also bought US Treasury paper ahead of the Fed purchases. On the other hand, the market speculated that the Fed would implement another round of quantitative easing, called QE3. This has kept the price fluctuations of the 10yr US T-Note future in a narrow trading range for several months and yields on 10yr T-Notes hovered slightly below the 2% level.

The precious metals profited from this development via three channels. The first one is the link between the price of precious metals and the US Treasury yields. The ultra-low yield level had reduced the opportunity costs of holding precious metals, which don’t yield any direct returns. The second link was via the foreign exchange rate. The expansionary monetary policy has lead to a weaker US Dollar against some major currencies. For the EUR/USD exchange rate, also the debt crisis in the euro zone played a role. Nevertheless, the stronger precious metal markets in the first two months of this year were accompanied by a weaker US dollar.

The third channel is via the stock markets. After the plunge in August, the expansionary monetary policy of the Fed was supportive for the stock markets. The tensions in the eurozone debt crisis caused some set-backs. However, after also the ECB took unconventional measures to flood the banking system with liquidity, the tensions eased. Of course, it was also helpful that economic data in the US surprised to the upside.

The FOMC provides an improved outlook for the US economy compared with the preceding statement. The committee has not provided any hint that QE3 would be implemented. While the FOMC continues “Operation Twist”, it also does not give any indication that this program would be extended beyond the scheduled end in June this year.

After the release of the FOMC statement, the US dollar came under pressure and a sell-off in the US Treasury market set in. However, the S&P 500 index still ended the week with a gain of 2.4%. This development explains that the PGMs declined far less in percentage terms than gold and silver.

Recent economic data indicates that the US economy is likely to expand further. The surveys of the Federal Reserve Banks in New York and Philadelphia rose stronger than the consensus of Wall Street economists predicted. The University of Michigan consumer sentiment index declined according to the preliminary data for March. However, the link between consumer sentiment and spending is not a very close one. Spending has increased also in the past despite falling sentiment. Therefore, we expect the US economy to expand further at around the pace seen in the final quarter of last year. But at a GDP growth of 3%, the Fed is unlikely to change its current policy stance. This implies even the risk that the current program of extending the maturity of its US Treasury holdings might not be extended.

Thus, the yield on 10yr US Treasuries might climb higher towards the 2.5% mark. Furthermore, the US dollar is probably going to hold fairly stable against major currencies or even to appreciate. Both factors would be negative for precious metal prices. However, an expanding US economy is likely positive for the stock market, which should also profit from shifting funds out of bonds into equities. This would be a supportive factor for precious metals and especially for the PGMs, which might perform better than gold and silver in the short-term horizon. But all in all, it has to be expected that the correction in precious metals markets is probably not over yet.

Also the flow of funds data points to a further correction. According to the latest CFTC report on the “Commitment of Traders”, large speculators have reduced their net long positions again. In the week ending March 13, they reduced the long positions in gold futures by almost 8,000 contracts to 190,477 contracts but increased the short positions by almost 5,000 to 39,571 contracts. Thus, the net long position fell by 12,359 to 150,906 contracts.

Some weeks ago, we argued that from a technical perspective gold should find support around 1,640$/oz. Gold has found indeed support at this level. However, also from a technical perspective, gold is not yet out of the woods. Some indicators point to an oversold market, which would argue for buying at support. However, the downward trend is still strengthening as the rising ADX indicates. This indicator is furthermore not yet at a level, which would indicate that the downward move is overdone. Also the MACD is still declining faster than its signal line. Thus, the knife appears to be still falling. Currently, we would stick to the old advice of never catching a falling knife.

Focus is still on Greece

At the beginning of the new trading week, the focus in precious metal markets is likely on Greece. After more than 85% of holders of Greek government bonds issued under Greek law accepted the offer of a debt swap, the Greece government activated the collective action clause. Late last Friday, the International Swap Dealers Association decided that this action would be a credit event, which triggers payments from credit default swaps. Normally, this should not be negative for the precious metals as this decision should have been expected. However, it can not be ruled out that stock markets react again negative, especially in Asian and European trading, and drag the precious metals lower.

Last week, precious metals prices came under pressure at the start of the week. The major reason was a drop in stock markets after China revised down the GDP forecast to 7.5%. However, the markets focused only on the headline in the media and fully ignored that the Chinese government also announced to take measures to promote domestic consumption. Also the uncertainty over the result of the Greek debt swap offer weighed on the markets. However, as it became clear ahead of the dead line that Greece would reach the required volume of debt swaps, stock markets as well as crude oil prices recovered, and thus, also precious metal prices moved up again. However, only gold managed to end the week in the black.

A negative factor was the US dollar, which strengthened further against the euro but also other major currencies. The euro initially weakened on the uncertainty about the Greek debt swap. However, on Thursday, the euro rallied against the US dollar on two factors. The first factor was the acceptance of the Greek debt swap offer. The second factor was the ECB. The council kept the refinancing rate unchanged. But more importantly, at the press conference, ECB president Draghi dampened hopes on further monetary stimulus. While the ECB staff projections lowered the forecast for GDP growth, inflation appears to remain a concern for some council members. But all the gains of the euro were given back the next day following the release of the US labor market report. The number of new jobs created exceeded again the consensus forecast of Wall Street economists. Thus, remaining hopes for QE3 vanished further. Some commentators at Bloomberg TV already talked about a Fed rate hike. While this is definitively far too early, the outlook for no further monetary stimulus is currently sufficient to support the US dollar. But as the ECB is probably also not going to provide any further expansionary monetary impulse, the upside for the US dollar appears to be capped.

After the plunge in the preceding week, it should not come as a surprise that the recent CFTC report on the “Commitment of Traders” shows that large speculators massively reduced long positions in the gold future. However, they have also closed short positions. Nevertheless, at the week ending March 6, they had lowered the net long position still by almost 30,000 contracts to 163,265 contracts. In silver, the large speculators have reduced their net long position by almost 7,000 contracts to 23,192 contracts. The holdings of the SPDR Gold Trust ETF remained unchanged this week. As precious metals recovered after the dead line of the latest CoT-report, we would not be surprised, if net long positions held by large speculators did not decline further.

Precious metals have stabilized in the second half of last week. However, they are not yet out of the woods. The technical indicators are still bearish. Thus, the consolidation is likely to continue for the time being.

Black Wednesday for Gold

While the other precious metals ended the month of February with a gain, gold suffered a huge one day loss, which wiped out the gains made during the month. Gold even fell below the close of January and thus, ended February with a loss. The trigger for this sell-off was disappointed irrational expectations.

Last Wednesday, Fed chairman Bernanke had one of the semi-annual testimonies at the Congress. And the sell-off set in with the release of the written text of his testimony. Normally, it is the case that words said move the markets. Just remember all the reports citing official sources from the German government, which moved markets during the last two years of the eurozone debt crisis. However, in the case of the Bernanke testimony, it was words not said which sent gold sharply lower. While the markets awaited an announcement that another round of quantitative easing would be implemented, the Fed chairman provided no hint about QE3.

Expecting that Fed chairman Bernanke would announce further measures of quantitative easing at a Congress testimony was rather irrational for several reasons. Central banks are eager to defend their independence. Thus, announcing policy measures at a Congress hearing could easily create the impression that the policy instruments were only applied due to political pressure or to please the Congress. Furthermore, it is not just the Fed chairman deciding about monetary policy measures, but all voting members of the Federal Open Market Committee. Decisions of the FOMC are released after the meeting in the official statement. In addition, the minutes of the recent FOMC meeting should include hints that the majority of the FOMC voting members would be ready to embark on QE3 at the next FOMC meeting. All one could find is the standard phrase that the Fed would be ready to act when needed. However, it is rather irrational to interpret this as a hint for announcing QE3 at the semi-annual testimony at the Congress.

When the Fed speaks, markets normally listen. However, this has not been the case recently. Only a couple of days before the Bernanke testimony, the governor of the Federal Reserve Bank of New York warned that Wall Street would have too high expectations for QE3. That still many hedge funds and traders expected an announcement of QE3 could only be interpreted as an irrational case of selective perception. This is another example for falsifying academic theory that financial markets follow rational expectations and are always information efficient.

The US labor market is improving, but the pace of job creation is too slow from the Fed’s point of view. However, this is not automatically leading to further monetary stimulus measures. The growth of US GDP also plays a role for the FOMC members in the process of decision making. The GDP growth in the final quarter of 2011 had been revised up to 3.0%. The capacity utilization is also pointing upwards and is not far below the levels prevailing before the financial crisis of 2008. Thus, the Fed could maintain the speed of monetary expansion but it is unlikely to accelerate further.

The US dollar strengthened after the Bernanke testimony disappointed traders hoping for another round of quantitative easing. However, QE3 is not a necessary precondition for a weaker US dollar. The Fed projected that exceptionally low interest rates will prevail until late 2014. The ECB is currently now showing any willingness to cut the refinancing rate below 1%. Thus, it is still attractive to borrow in US dollars and to invest in other currencies. Therefore, the US dollar is probably to remain a supportive factor for gold in the medium-term. However, it could not be ruled out that the US dollar would be regarded as a safe haven in a geo-political crisis, especially in the Middle East. But in such a crisis, gold would probably also be sought as a safe haven.

The technical picture for gold has worsened considerably due to the plunge on Wednesday. It could not be ruled out that the rise on Thursday is just a typical “dead cat bounce”. However, there should be some solid support in the range between 1640 – 1650$/oz. Currently, we would regard a test of this level as a good buying opportunity.